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I'm a private investor and I pride myself on an analytical approach
to investing. I try very hard to look at things from a scientific
perspective of risk vs. reward. It is an indomitable tenet, one that I
attempt to instill within my three children, and one which has (at
least for the last 8 years or so) has provided me with an investment
return that is multiples of the broad market. Unfortunately (or maybe
fortunately, in regards to my investment record), it is one which is
not shared by most of the analyst community and those that follow them.

This brings me to the issue of Goldman Sachs. I have been bearish
on commercial, mortgage and investment banks for over a year now, and
have made a penny or two from this outlook. In doing this, I noticed
the illogical reverance that Goldman Sachs has recieved, both from the
analytical community and the media (bolstered by the name brand talking
heads). I never did buy into it. Goldman is a fine, well run, well
respected brokerage/banks, but it is still just that. They hire the
same people, who went to the same schools to get the same education, to
use the same strategies to trade/advise on the same products in the
same markets as all of the other banks. To assert that thier shit
doesn't stink breaks from my scientific method of analysis. So, let's
take a more analytical look at the media's Golden Boys...

As you can see above, Goldman actually tends to move in tandem with the rest of the street.

Their share

Correlation to date

77.95%

GS and MER

84.98%

GS and LEH

69.57%

GS and MS

Correlation before Securitization Crisis Starts (10/06)

91.26%

GS and MER

91.57%

GS and LEH

56.19%

GS and MS

price returns have a very high correlation with their competition. This correlation was strong for the last 8 or so years, then weakened considerably. What happened? The Asset Securitization Crisis happened (click here for the latest installment in the analytical series). During this crisis, GS put out vastly superior (though still bad) numbers as compared to the rest of the Street. Why is that? After all, if you look at the other major crisis of the decade, the Dot.com bust, GS got crushed just like everybody else. Well, I know why GS was able to put out better numbers. They took more RISK! Risk is the price one pays for reward. Goldman was able to put out relatively strong numbers, but they are paying through the nose for it. They are paying so much that it is bound to come back to bite them in the arse. Judging the historical correlation between GS and their brethren, I am led to believe that their is a very strong chance this stock will nosedive. There are other things that lead me to this conclusion as well, though.

Risk vs. Reward is what the successful investor looks at when gauging an oppurtunity. The Street and the media are just looking at reward in regards to Goldman Sachs!

We have looked at company’s recent quarterly filings and 10K to have a closer view of Goldman Sachs’ (GS) exposure. Following are some of our observations:

Goldman has the highest VAR among its peer group of $184 mn, followed by Lehman at distant $123 mn (we all know how well LEH is currently faring). Notably, GS also the highest range (difference of highest and lowest daily VAR during a quarter) of daily trading VAR of $92 million, reflecting significant (read risky) volatility in its trading portfolio. This is higher than $61 mn and $67 mn (for 1Q2008) for Lehman and JPM, respectively. This is also being reflected in the lowest risk adjusted return on risk adjusted capital (RARORAC - a much more grounded measure of risk adjusted return) of 14.8% for GS among its peer group. Just so this doesn't escape anybody, GS has the lowest risk adjusted return on the Street. Simply analyzing earnings (or looking at CNBC) would lead one to believe that Goldman has the highest return on investment, but unfortunately, the world is a bit more complex than an earnings statement or a cable news channel.

Average Daily Trading VAR (in million dollars)

Q208

Q108

Q407

Q307

Goldman Sachs

184

157

138

139

Morgan Stanley

99

97

89

87

Merrill Lynch

NA

65

65

76

Lehman Brothers

123

130

124

96

JPM

NA

122

107

112

Range of Daily Trading VAR (Difference between highs and lows) (in million dollars)

Q208

Q108

Q407

Q307

Goldman Sachs

NA

92

77

68

Morgan Stanley

NA

34

46

36

Merrill Lynch

NA

39

51

32

Lehman Brothers

37

61

107

66

JPM

NA

67

138

64

Risk Adjusted return on risk adjusted capital (RARORAC)

Q208

Q108

Q407

Q307

Goldman Sachs

12.9%

14.8%

16.1%

15.3%

Morgan Stanley

19.7%

19.1%

21.5%

23.3%

Merrill Lynch

NA

31.6%

32.5%

30.5%

Lehman Brothers

14.0%

12.3%

12.0%

15.3%

JPM

NA

54.1%

60.2%

56.8%

Goldman also has the highest adjusted leverage ratio (adjusted asset divided by adjusted equity) of 18.6x (for 1Q2008) among its peer group, reflecting lower equity cushion against any valuation write-down or loss. This highest leverage portends much greater volatility in economic earnigns. In other words, when the win chooses not to blow in their direction, the sh1t will hit the fan that much harder than the rest of the Street

GS’ level 3 assets as percentage of its equity at 258% is close to highest figure of 274% among its peer group. Its level 3 assets proportion to total asset has increased consistently from 5.7% in 2Q2007 to 8.1% in 1Q2008.

It is also worth noting that approximately 25% of its OTC derivative credit exposure (comprised in level 3 assets) is rated BBB and lower.

OTC Derivative Credit Exposure ($ mn)

Feb-08

% of total

Nov-07

% of total

AAA/Aaa

$15,387

15.6%

$14,596

20.7%

AA/Aa2

$33,820

34.2%

$24,419

34.7%

A/A2

$25,291

25.6%

$16,189

23.0%

BBB/Baa2

$9,724

9.8%

$6,558

9.3%

BB/Ba2 or lower

$13,354

13.5%

$7,478

10.6%

Unrated

$1,236

1.3%

$1,169

1.7%

Total

$98,812

100.0%

$70,409

100.0%

In March 2008, Standard & Poor’s affirmed Group Inc.’s credit ratings but revised its outlook from “stable” to “negative.

On a positive side, the investment banks’ has been able to withstand the current turmoil in the credit market and has been the best performing banks when looked at mark-to-market writedown of its asset portfolio. I must note that it is my belief that this immunity to the markdown mania was achieved by the very risky trading in hedges and opposing positions. This is most likely what drove up the risk comonent in their economic capital. In 2Q2008, the writedown in cash instruments and other assets was more than offset by gains in derivative contracts. It also seems to have one of the lowest exposure exposure into Alt-A and subprime asset categories.

However, recent change in some of the variables (level 3 assets, VAR, adjusted leverage ratio) indicate that the bank may be susceptible to slowing capital market activities and further deterioration in the credit and financial markets.

Needless to say, Goldman has earned itself a full forensic analysis. I will report back when I have the results.